Chapter 1 - Derivatives (1) Flashcards
Derivative definition
A financial instrument whose value is dependant on (or derived from) the value of another, underlying asset.
Two (2) distinct marketplaces for derivatives
- Exchanges
- Over-the-counter (OTC)
Futures contract definition
A standardized, exchange-tradable contract between two parties to trade a specified asset on a set date in the future at a specified price
Cash market or Spot market is often used to refer to the market for the underlying
Tick size
Minimum price movement for a contract on an exchange
Clearing house
- Checks that the buy and sell orders match each other
- Acts as “a party to every trade”
Advantages of a clearing house
- Removes counterparty credit risk
- Since contracts are standardised, participants can ‘clear out’ position without finding original partner.
Margin
Collateral each party must deposit with the clearing house.
Initial margin
Amount deposited when transaction is first struck
Variation margin
Additional payments made on a daily basis to adjust margin based on price movements to control counterparty risk
Maintenance margin
Level of margin account below which a a variation margin must be desposited
Delivery (in futures market)
Refers to the settlement process
Open interest
Number of contracts outstanding at any one time
Option definition
A contract between two parties to trade a specified asset on a set date in the future at a specified price
The holder of an option is not obliged to trade (hence the name option)
Call option
Gives the holder the right, but not obligation, to buy a specified asset on a set date in the future at a specified price
Put option
Gives the holder the right, but not obligation, to sell a specified asset on a set date in the future at a specified price
Exercise price / Strike price
The price at which an underlying security can be sold to or purchased from the writer of an option
Margins (with regards to options)
Only payed by the writer of the option as the buyer has no obligation to exercise the option and therefore poses no counterparty risk
Main advantage of the OTC market
Ability to tailor contracts to the buyers precise requirements
Main disadvantages of OTC market
- Non-standard contracts reduce/eliminate marketability
- High dealing costs
- No quoted market values
- Greater credit risk
Forward definition
A non-standardized, privately negotiated contract between two parties to trade a specified asset on a set date in the future at a specified price
Swap definition
A contract between two parties under which they agree to exchange a series of payments according to a prearranged formula. Generally sold in the OTC market
